Wednesday, October 25, 2006

Inside The Trader's Brain: Decision-Making and Emotional Arousal

For years, behavioral finance researchers have been aware that people's decision making is greatly affected by how choices are framed. For instance, the same monetary bet framed as a choice between a certain vs. risky gain and a certain vs. risky loss elicits very different choices. (We tend to take certain gains, but will seek risky losses to avoid certain loss). Studies using functional magnetic resonance imaging (fMRI) find that we expend less cognitive effort in taking a sure gain than in choosing risky gains, sure losses, or risky losses. It may well be that traders don't let their profits run simply because they take the easy way out cognitively. Conversely, traders may be reluctant to set and follow stops because of the greater cognitive effort required.

It turns out, however, that this taking the easy way out and avoiding difficult decisions may not be a function of laziness. A very interesting investigation coming out of the Institute of Neurology at University College London finds that the framing effect on decision making is mediated by an emotional center within the brain: the amygdala. This is the same brain center that cognitive neuroscientist Joseph LeDoux has linked to our response to stress and trauma.

The implications are significant. When blood flow is directed away from the brain's executive center, the frontal cortex, and the amygdala and associated emotional centers are activated, we are likely to underutilize those executive functions--reasoning, judgment, planning--and respond to our (emotional) framing of choices with a lack of effort. Going with our feelings might just be the reason we don't think through our choices.

It is also likely that we frame our choices differently during periods of focus/concentration vs. emotional arousal. Stressful episodes in the market, activating the amygdala, are likely to elicit a framing that is different from the careful trade planning we conduct when we are cool and calm. Research, for instance, finds that fear and anger color our decision making about preparing for terrorism-related risks. Emotional factors have also been found to color decision making about economic choices.

This helps to explain why I have found biofeedback to be extraordinarily helpful for traders who experience emotional disruptions of decision making. By working with traders in stressful situations and having them control their level of arousal during these episodes, biofeedback enables them to retain access to their executive capabilities. In a very important sense, successful traders train their brains for accurate decision-making under stressful circumstances.

Sometimes, looking back on our trading decisions, we wonder if we were in our right minds. How accurate that concern turns out to be! Some of the best trading psychology interventions are the ones that keep us in our right minds as we make decisions under conditions of risk and uncertainty.

6 comments:

Good advice. I can feel my mind and body wind itself into a knot when stress becomes too great. My judgement gets clouded and my trading gets erratic and sloppy. I'm well researched and prepared, but the inability to master my emotions is something that has hurt my performance. My father has been in the business for 25 years and I am in awe of the way he can control himself at all times regardless of the situation. I hope that get to that level.

I think rookie soldiers go through the same thing. It's a matter of training: making the unusual usual and going through stressful situations so often that your responses become automatic. I suspect your father gained his cool by being under fire many times. Thanks for the note--

Great article. I like your posts that have more to say on psychology and neuroscience.

"It may well be that traders don't let their profits run simply because they take the easy way out cognitively. Conversely, traders may be reluctant to set and follow stops because of the greater cognitive effort required.". I like it because this is a very good explanation of Prospect Theory and sometimes I feel the same way - find it difficult to recognize lose than win. And this is the challenge - recognizing fast (accepting) loses. I think traders have to put more work on this side.

"A very interesting investigation coming out of the Institute of Neurology at University College London finds that the framing effect on decision making is mediated by an emotional center within the brain: the amygdala." Trading isn't easy because we process information through filters (emotional center) that react quicker than our rational mind. As you say the point is not to eliminate those filters, because it is impossible, but to try to measure them in order to know when to trade and when not to trade. And that is why most traders fail to recognize easily losing trades - because amygdala gets the control over their trading and they are not in their right minds.

That's a very good point. Our emotional processing of events occurs more quickly than our thinking about those events, which means that, if we're not prepared for the events, emotions are likely to take us by surprise and potentially interfere with judgment and decision making. To recognize losses and quickly respond means that we have to be *prepared* to lose.

About Me

Author of The Psychology of Trading (Wiley, 2003), Enhancing Trader Performance (Wiley, 2006), and The Daily Trading Coach (Wiley, 2009) with an interest in using historical patterns in markets to find a trading edge. I am also interested in performance enhancement among traders, drawing upon research from expert performers in various fields. I took a leave from blogging starting May, 2010 due to my role at a global macro hedge fund. Blogging resumed in February, 2014, along with regular posting to Twitter and StockTwits (@steenbab).